Investors must contend with a painful but critical risk of investing.
The resignation of Ernst & Young (EY) as Super Micro Computer‘s (SMCI -32.67%) accounting firm sent its stock reeling. Not only did its stock plunge but now investors must also contend with one of the more promising tech growth stories getting derailed by alleged accounting irregularities.
Considering this challenge, Supermicro has instead become a painful investing lesson. Unfortunately for investors, there’s only one way to mitigate the potential consequences of such issues.
What happened?
EY’s resignation forces even Supermicro bulls to look at the stock in a negative light. In July, EY expressed concerns regarding its internal controls over financial reporting, questioning whether it had sufficient controls, governance, and transparency. Now, after receiving “additional information,” it has decided to resign.
In its resignation letter, EY said:
We are resigning due to information that has recently come to our attention, which has led us to no longer be able to rely on management’s and the Audit Committee’s representations and to be unwilling to be associated with the financial statements prepared by management.
Supermicro immediately expressed disagreement with EY’s decision to resign. Nonetheless, it has still not released its delayed annual report, and the resignation is a major setback in the company’s quest to win investors’ trust.
Indeed, the extent of Supermicro’s accounting challenges remains unknown. However, the high level of uncertainty makes it nearly impossible to treat Supermicro stock as an investment under such conditions. Hence, shareholders who bought this AI stock for anything other than a speculative play should get out now. If you keep your shares, make sure you’ll be able to absorb any possible loss.
The investing lesson
Unfortunately, the incident has given investors a painful reminder of a critical investing lesson: Diversification is the only tool investors have to protect themselves from a company’s accounting issues.
Ultimately, one can only rely on company reports and filings to understand a company’s financials. They also have to act on faith that regulations and accounting audits will protect the integrity of the reports.
In this case, it was also difficult for investors to predict this challenge. Most signs pointed to Supermicro’s growth story being plausible, and I am one of the shareholders who believed it. The growth of Nvidia‘s AI chip business appeared to corroborate Supermicro’s explosive growth, as it is one of its key partners. Although the AI growth opportunity could still be accurate, the extent to which the company actually capitalized on it and how that is reflected in its financial statements remains in question.Â
The only meaningful evidence investors could find to doubt the story was another accounting investigation of Supermicro’s books between 2014 and 2017. The company subsequently issued a correction in its May 2019 annual report and paid a $17.5 million civil penalty in 2020.
However, Supermicro was not a widely followed stock at that time. Thus, it is likely most of the company’s newer investors were unaware of this past investigation.
Moreover, even if one knew about it, it was reasonable to assume the company had learned its lesson. Accounting irregularities can lead to massive fines and news that hurts a stock’s performance. In more extreme circumstances, it can also land executives in jail. Such consequences tend to prevent most significant accounting irregularities from occurring.
However, EY’s resignation shows that tight regulations and penalties cannot always prevent such issues, and investors need to take preventative actions in case such incidents take them by surprise.
Moving on from the lessons of Supermicro
Ultimately, diversification is the only way to protect oneself from a company’s accounting irregularities.
Most individual stock investors are already diversified and have positioned themselves well to recover. In other cases, this incident may put off some investors from individual stock investing.
Fortunately, investors can turn to mutual funds or exchange-traded funds (ETFs) that can do the heavy lifting involved with stock selection. Some of these funds can even match or beat market averages.
What investors should not do is leave investing altogether. The S&P 500 (^GSPC -0.33%) has offered an average total annual return of approximately 10% for almost 100 years. That average accounts for company failures and all types of economic downturns, protecting the individual investor.
In the end, individual companies can let us down. Nonetheless, shareholders can still serve themselves best by staying invested in well-managed companies and employing safeguards such as diversification to protect themselves from unexpected issues.
